Monday, February 10, 2014

Blue Nile and Marc Andreesen's theory of public company shareholders, oh and a valuation of Amazon

Marc Andreesen (@pmarca for the must-follow twitter account) has been toying with a theory of public company shareholder. The short (Twitter) version is "At any given time, public co's shareholder base consists entirely of one of: growth investors, value investors, arbitrageurs, or nobody." This has been refined through tweets.

The growth investors will hold a stock as long as the rate of revenue growth does not slow. When it slows they dump - and the shares of really fine companies can fall sharply because the growth rate falls from (say) high single digit to mid single digit. What are objectively great results can see 25 percent price falls simply because the results do not measure up to the expectations of the shareholder base.

The growth investors don't much care about earnings (they come later). But they do care how big the eventual market becomes.

A recent example of a fall (which may or may not be justified) is Amazon who were seen missing lofty expectations for Christmas sales. [The sales numbers were fantastic, just the expectations were more fantastic.]

A fallen growth stock doesn't become fashionable again until it has a lower-than-market price-earnings ratio where it attracts "value investors". Value investors have a different agenda. They want the business run for cash and maybe for buybacks. Shareholders will pressure management to meet their expectations. [Example: Apple.] If earnings fall or buy-backs slow these shareholders are disappointed.

Below the value investors - and mentioned in later tweets - are the Ben Graham style bottom feeders who get really interested when the stock is trading at half cash. Whereas traditional value investors want the business run for cash the true bottom feeders want the business closed for cash. Zynga at bottom was borderline of interest these investors.

Outside this are the arbitrageurs that just want to rent the stock for a short term deal. No deal and they are disappointed.

This is a generalization. But being a non-conformist at heart I want to look at the places between - stocks dumped by growth investors for example before they become interesting to value investors - or stocks that are approaching Ben Graham levels but still have viable businesses.

Between the cracks are interesting places to look. Zynga was interesting at the edge of being a Ben Graham stock. Google's had a slowdown that lasted one quarter. Buying a growth stock when the slowdown is temporary and lasts one quarter provides great opportunities. See January 2012 where Google dropped a double-digit percentage in a sharply rising market.*

So I am going to look at a twixt-and-between stock: Blue Nile. This is a failed growth stock that doesn't yet have a low PE and has an enormous short interest. The company recently missed and guided revenue and earnings down - which is problematic for a stock with a 50 PE ratio.

The knock on the stock: it has been missing expectations for years.

==

The Jeweller with one of the all-time-great business models

Blue Nile has possibly the most seductive business model I have ever seen. It is an online build-your-own seller of engagement rings.

The modal purchaser of an engagement ring is a man in their 20s or the 30s who doesn't give two hoots about jewellery. The purchase is large (a month's salary?) and is full of terms that he doesn't know (VS2 clarity anyone). He is buying it for someone who he hopes will accept his proposal.

The ideal customer provides no return business. Ever.

The total absence of return business means that the downside for ripping customers off is low. [They are not coming back so if you gouge them it won't matter.] The high-ticket price and the general ignorance of the customer guarantees a rip-off. If the customer is at all sophisticated about human nature they know it.

The shop-keepers know this too. They have glamorous premises (which just adds to the feeling of being ripped off). They use lighting tricks to make the diamonds sparkle. And the sales guys are - in my one-off experience** - a less explicitly testosterone laden version of car salesmen. Slick. Dishonourable. But smooth, so smooth.

Into this comes Blue Nile who offer diamond engagement rings on a build-your-own basis with transparent pricing. You go to their site and choose one stone, three stone, this clasp, that clasp, this quality and size of diamond etc. They tell you if you are choosing a quality of diamond so high you can't tell the imperfections except with a microscope. As you move the slider up choosing a bigger diamond or a higher quality diamond the price changes and you can see the price change so you know how much you are paying for size/quality and settings.

The margin is thin - so there is no way you can feel "ripped off" and it comes in a blue-box which to my (admittedly unsophisticated eye) is just a darker, richer shade of blue vis the expensive boxes sold by Tiffany's.

It is also a truly great business model. Transparent pricing makes a guy keen to shop there. But the real joy is the negative working capital.

A traditional jeweller sits huge amounts of inventory around waiting for a victim (ahem: customer) to come through the door. They need to sell at a price high enough to get a return on all that inventory. Zale Corporation has $900 million in inventory. That inventory is the majority of their assets and represents about a year of cost of goods sold. The first 10% of margin is just getting a return of 10% on the inventory holding. Tiffany is even worse with $2.4 billion in inventory and annual cost of goods sold of $1.7 billion. They have 17 months inventory sitting around glistening under expensive lights and more expensive security. Margins need to be enormous just to give a return on inventory holdings.

By contrast Blue Nile recognizes diamonds are commodities and doesn't bother with all that inventory. They just buy-to-order. If you want a round-cut three-quarter carrot diamond with an ideal-grade cut and VS2 clarity it will cost you about two and a half grand and one is pretty well like another. So Blue Nile take your money, build the ring to order and ship it to you. Turn-around is not fast but is adequate and Blue Nile operate with negative working capital. At the last (and disappointing) numbers Blue Nile has $34 million of inventory (mostly non-engage ring product) and $134 million in accounts payable. The offset is a cash balance well over $100 million.

And Blue Nile can sell much cheaper than a traditional jeweller. A traditional jeweller with this turnover would carry maybe $350 million more inventory and would require a return on that. They would also need security and insurance for that inventory and would pass that onto customers. On top of that there are no premises and slick dishonourable sales people to pay. All this would add up to more than 20 percent cost advantage.

The advantage that Blue Nile has over its competitors is much bigger than the advantage that (say) Amazon has over Best Buy.

If you had that advantage the rational thing to do is to price really keenly, be as honest and transparent as possible and grow and grow and grow some more.

In other words to do what Amazon does.

One day - sometime in the dim-distant future - growth will slow because you have captured the market and then you price with say a 8% margin and mint money.

The maths will look like this. We don't know what the "end-sustainable sales" are but for every dollar of sales there is 8c of margin. Post tax there will be about 5.6 cents of earnings. Put that on 13 times and the stock will settle out at 72 percent of sales.

If end sales are a billion the market cap will be $720 million. If they are 5 billion the market cap will be $3.6 billion.

This maths gives you the quick way of valuing Amazon. Amazon sales are currently $75 billion. If they quadruple between now and maturation the end sales will be $300 billion. The end market cap will be $210 billion. The current market cap is $165 billion. If Amazon can quadruple sales the stock will be a winner. I think it probably will. But to do really well on the stock sales probably need to rise 600 percent. [We have no position in the stock.]

Alas Blue Nile is not Amazon. Despite what looks like a massive advantage and a near perfect business model Blue Nile just has not grown that fast.

In 2008 Amazon sales were $20 billion. They are now $75 billion. Sales have better-than tripled.

By contrast Nile has disappointed. Sales are only up about 50 percent. And in that time margins have slid so earnings are flat. Earnings are flat at Amazon too but nobody gives a toss. All they care about is the sales growth.

But they do give a toss at Blue Nile. Blue Nile guided for earnings/margins and missed. And their sales growth has slid to low-teens. It raises the question: if they really have a better business model why isn't it growing at the torrid pace that Amazon is growing.

The obvious suggestion is that engagement rings are such an emotional purchase that the bride-to-be really wants to see it and hence shops traditionally. And despite the movies men don't often get down on a bended knee and offer a surprise proposal ring-in-box proffered up ready for rejection. [I would have been way too insecure...]

And so the end market for Blue Nile is just not that big.

==

But there are offsets. Blue Nile does have a reputation for not ripping you off. I can imagine plenty of Chinese want loose diamonds as a form of portable wealth. The end-market here could be enormous. If Blue Nile can capture any of that the sales will be huge albeit at low margins.

And there are some technologies out there which will make Blue Nile a very much better business. The Oculus Rift is one of the hottest venture capital concepts. Cheap highly realistic 3-D virtual reality headsets are coming. 3-D scanners will also be under $100***. When you inspect real-estate online you will be able to walk in your headset through the house in realistic, high-resolution 3-D. When you buy jewellery online you will be able to see how it looks on your (or your bride's) hand. And you will be able to tweak it so you know when that stone really is so large it is grotesque. In other words online shopping will be a much better experience.

==

The value proposition in Blue Nile stock

Trailing sales are $450 million. The market cap is $442 million. Sales are growing still but the rate is disappointing. The PE ratio is over 40 but that is because the business is not earning much margin.

It is not a value stock yet. The PE is way too high.

Rather the stock is held by disappointed growth investors. After all this was the perfect business and it didn't perform.

Also it is closer to 1.0 times sales than my magical-end point of 0.7 times sales. It will get to 0.7 times sales one day - either by the price declining further or the sales increasing. Given the low-teens growth rate getting there via growth seems likely to me albeit at a slow-grind for shareholders.

In other words Blue Nile is twixt-and-between. Its not a great growth stock and is hardly a value stock.

It wouldn't be much interest to me except that it has a short interest of 20 percent of the float, is more than 115 percent owned by institutions and is - on the metrics above only about 20 percent overpriced. After all it will wind up as a value stock one day at 0.7 times sales.

We are in a market where lots and lots of stuff is more than 20 percent overpriced. So I don't get it. Can someone please explain the short interest? Do the shorts really believe this deserves to trade at half sales?

==

Why we own it?

When stocks have a very high short interest and the shorts are wrong the stocks are unbelievably large winners. Think Tesla, Netflix and - dare I say it Herbalife.

So far on Blue Nile the shorts have not been wrong. This is a company which is disappointing on growth and disappointing on margins. But as I noted there are things that can go right.

Top of my list is the Chinese developing a fascination with loose diamonds. The amounts of money here are enormous - and as a general rule I don't want to be short Chinese corruption. Chinese corruption is a very big market.

Maybe more certain: the Silicon Valley guys are completely obsessed about the Oculus Rift and immersive and cheap 3-D experiences. They are early (which is their job). Still I don't want to be short a real 3-D stock. Cheap 3-D technology will change the online shopping experience dramatically. I can see Blue Nile sales eventually quadrupling - in which case the stock is very cheap indeed. But that eventual sales growth relies on technologies that will not be widespread this year and are not part of Blue Nile's publicly stated plans.

John

*I remember well. We were long. January 2012 was our worst ever month.

** I am married to my first wife. Shopping for an engagement ring really was and will remain a one-off experience.

I hope to find the transcript of their latest full year 2013 earnings conference call for the Q&A. Always handy information.

In the Q2 2013 Q&A they mentioned they "have sold, both on the phone and the tablet, items in excess of $200,000. I think our biggest ring on a tablet was $250,000 and I think $226,000 engagement setting on a mobile phone". The talk is mostly around settings so would be interesting to see any trends in loose diamond sales versus set.

John, I have a question about inventory: you seem to be suggesting that when Blue Nile provides the searching used with hundreds of diamonds to meet his search criteria, that NILE doesn't own those diamonds in inventory?

is that what you're saying?

if they don't own them, where are they pulling those results from? I can't imagine that there's a sort of central diamond database that all of the diamond dealers pull from, but I could be wrong...

you mentioned cut-to-specs, but NILE shows grading certificate numbers and copies for their diamonds - these diamonds are definitely already cut...

For a 3/4 caret diamond of VS grade (ie every $5000 engagement ring in the US) the price is so well determined and the supply so large they can just put it up and buy it on demand.

As the demand is so common for these they probably have a few in inventory at any time - but even then THESE ARE A COMMODITY.

If you go look at non-commodity diamonds (say 3 carets, ideal cut, superfine clarity) they only have a handful and they do not have every grade. My guess - and it is a straight guess - is that some of these are dealer inventory and the dealer has ability to put them on the system in price ranges.

But the size of that market is small.

If you go Signature Ideal cut, 3 caret, top clarity you can spend $300K. For low clarity you spend 10% of that.

If you want .7x sales that has already come out of deep value try DangDang DANG US. The turn around is being driven by shift to a market place model better margins etc. It is already also number 2 in flash sales after Vipshop VIPS US which trades on 3x sales (mkt is huge as China doesnt really have outlets like US/Europe). DangDang also is still number 1 in books. 27th of Feb will prove if turn around real all not, place your bets.

what I'm saying, though, is that almost every diamond I have looked at on Blue Nile has a copy of the grading certificate online...

so I have no doubt that these diamonds are commoditized, but NILE is selling their customer a very specific diamond. see? they are not going out and obtaining a commodity that fits my specs after I purchase it...

I was short it in the past, although this was when the stock was $50+ (3 years ago). There is a fair amount of competition for online engagement ring sales now, although I agree with you that NILE has the best reputation. Also, when diamond prices are going up they tend to do poorly and vice versa; traditional retailers have better priced inventory they can sell when prices have gone up and NILE is more competitive when prices have gone down. Right now there is no meaningful trend in diamond prices and not coincidentally I think they aren't growing or shrinking dramatically.

I do think the stock is still relatively expensive given the lack of growth. Reality is they only generated $18 million of FCF last year and that figure was down. Just because people are short it doesn't mean it is going to squeeze if it's uninspiring.

You seem fairly optimistic regarding the market and margin for Blue Nile. Zales and Signet have the same kind of build your own ring functionality...clearly Blue Nile has a much better website right now, but Signet's Kay's gives you the same kind of choices along with stores that allow you to see rings in person. Signet, by the way, has much better inventory turnover than what you are describing as normal for the industry using Zale's.

Could Blue Nile be a target for Signet's clean balance sheet? Blue Nile doesn't seem to advertise anywhere...Kay's/Jared are everywhere.

Having recently bought a ring, I am skeptical as to how much of an advantage Blue Nile has. Over and over, I hear about people falling in love with one ring that they found after going to several stores...they create the idea that this was the ring meant for them. Hard to do that online. Are they actually a commodity if everyone believes their stone is a one and only, even if you know they clearly are a commodity? By the way, I bought truly commoditized wedding bands from Amazon very cheaply. The whole process of ring shopping is so dumb.

Blue Nile requires wholesalers to keep the specific diamond in inventory while NILE has it listed on their website.

The main issue here is the grading system and how retailers actually purchase loose diamonds from wholesalers.

The GIA will often misgrade a diamond (so many of the grades are subjective), or there'll be a pattern of inclusions in the I2-VS1 range that are less desirable than other inclusions. From the retailers perspective, their customers will pay less for the flaws they can see, therefore they are unwilling to buy these diamonds from the wholesalers.

On Blue Nile, however, all you see are the diamond's stats. Few people look much deeper (i.e. into the pattern of inclusions, the actual dimensions of the diamond - table size etc). The "lower" price on Blue Nile is largely for inferior diamonds within the same overall "grade".

The great-stupid-Chinese market is the great-white-asset manager's favorite bogeyman. Despite certain cultural tendencies to overspend (shared with the newly-rich in any society), Chinamen are not stupid as a group (at least, not more so than any other demographic). The concept of "diamonds as an investment" is one DeBeers has tried to float in the 80's. I imagine it'll have similar lack of traction in China as it did elsewhere.

Also, it's MA's "hypothesis" (and a weak one at that), not a "theory".

Unless their business model changed in the last couple of years, most of the diamonds listed on their website are the inventory of the wholesalers/cutters, who also supply to retail stores. The wholesalers list their inventory on Blue Nile and when somebody actually purchases the diamond, which includes a mark up for Blue Nile, Blue Nile purchases it from the wholesaler.

When diamond prices go up sharply like after the financial crisis, the wholesale prices move right away. Retailers, who carry inventory, benefit from the lower cost basis of their inventory and try to drive sales by not increasing their prices as aggressively. This is the problem Blue Nile had for a while.

I ended buying a $20,000+ diamond for my wife's ring from Blue Nile. Similar quality diamonds were 30% higher at retail. In addition, you have to pay taxes unless you have the jeweler ship the ring to an out of state address.

The problem for a lot of people is trust. Most people do not want to buy something that expensive without looking at it, touching it or talking to somebody in person.

The other problem is the fact that women want to be part of the buying process. Online jewelry shopping does not provide the same satisfaction for women as going into some well lit shinny jeweler.

1) The negative working capital is driven by the use of cash to repurchase shares. Otherwise it would be small (7% quarterly sales) but positive.

2) Your thesis is that the company should be valued on the theory that eventually it corners a market niche. But there are oodles of companies in the cheap diamond and online engagement-ring businesses. Less the future-monopolist concept, they're a discount, low-margin retailer (ultimate expected P/E ratio 15x) that happens to be in a high-growth (10% yoy) phase, but is also loaded with stock compensation for the employees. How do you get to the existing 40x P/E? Maybe I'm just an internet-retailer-earnings-multiple skeptic.

3) Doesn't the amount of share buy-backs and decision not to take on some kind of tax-shield debt imply that they don't see aggressive growth in the near future? If they wanted to act like a growth stock they should be putting more of that cash into marketing. I'd never heard of the company before your post. (It is a nice website.)

Great post John, I think a lot of comments miss the point around the process of your work and thesis behind it. Whether Blue Nile turns out to be a good investment is subject to many other factors I think it is besides the point. But what is very interesting, and missed by many value, P/E, DCF guys is the fact that many tech based businesses and even eCommerece (which I would say is relatively low tech) cannot simply be valued by traditional metrics. While I disdain the EV/Revenue calculation which is so en vogue for biotech currently, it does have its uses, especially when the ultimate business model is somewhat evident. And these businesses models are much different than you 1960's based GAAP manufacturing/retail companies. Earnings doesnt always capture the value (think of Buffet and his love for brands)

The other point I would like to make, regarding Andressons market player categorization is that you have to consider the time horizons of all the different players. Short term traders do play a large role in swings in the price of many momentum stocks. It is very interesting to think about the role of different players and andrew lo of MIT has written some interesting market evolutionary papers on this.

Regarding Blue Nile I see it was not as expensive as you originally suggested (if it keeps growing double digit). They ended 2012 with almost 50 millions net cash

Ofc the tricky part is to understand if growth is sustainable, the short sellers were probably targeting the company for competitive/execution issues.

Buffett bought Borsheim's because of high inventory turnover, operating efficiency, ability to buy large quantities at low price compared to the typical jewelry retailer and great customers service and reputation. So I would start from these attributes looking for a standout in the business...If you sell jewels your inventory is very valuable so the small shop has to sell at big markups to get a decent ROC but if your turnover is higher and you can reach a broader customer base(ex. online) you can kill your competitors.

Blue Nile is not the best in inventory turnover but I would suggest that online jewels are so cheap for a reason and the shift is happening less physical stores more online retailers... So this market has many tailwinds but competition is difficult just like auto parts, only the best can make good profits.

FWIW (not very much) I considered buying based on your post, but asked my (12 year old, so not exactly the target market) daughter first, who said "I would prefer to see it beforehand, it is much better if you can actually see what it is you are looking at. if it was a lot cheaper (and I mean a lot) then I might buy it online, but in store is still better."

John, enjoyed the simplicity of the thesis. The challenge here is that Blue Nile has not reached a tipping point. Very few people who do jewelry shopping have even heard of Blue Nile and the mindset change required to buying jewelry online is substantial. Something will click one of these days but the real questions is if Blue Nile will be a relevant player when the paradigm shift occurs. $400M a year is not a bad place to be. They are definitely at the front of the pack and the chances are good. But, comparing with giants like Amazon is a long, long way away (Amazon could purchase Blue Nile - wouldn't that be something)

Those of you who believe online jewelry will never be big, think about used cars - that is a big online business now. The average used car is a lot more expensive than the average piece of jewelry, and far more can go wrong with a car and the consequences are difficult to deal with. Yet people buy online. As far as complexity of diamonds, think of the dozens of options on a single car model. Hard to trust diamond dealers online? Not as hard as used car dealers.

I looked at Blue Nile as a long about a year ago. I also happened to be looking to buy an engagement ring for my now wife. So I had an opportunity to do some very real research on the product and business. A few takeaways, which are likely obvious to you already, but are the reasons why I did not like the stock.

1. There's no replacement for the lights and "experience" of a jewelry store. They're designed to make those stones sparkle. It works, and it sticks in your wife's mind forever.

2. The packaging of the Blue Nile ring looked cheap. I ordered 5 rings to look at; they came in these ugly clunky wooden/plastic boxes. How they can miss a basic thing like packaging is a real question in my mind.

3. The rings and stones themselves were not very attractive. We went to 5 jewelers at least. We both decided to spend 50% more and get a diamond that sparkled more and a ring that really fit well. Obviously, that's taste, but I felt the product wasn't up to par, frankly.

4. I'm not sure about the "shipping" model for diamond engagement rings. I'm a terrible shopper online; I pick out 5 rings for my wife to see, she sees them, she doesn't like any, I have to return them all; repeat, repeat, repeat. Much more time consuming that going and looking at 200 rings in person.

5. After my experience, I'm not sure that Blue Nile has a strong brand. It has a strong connotation for sure -- it's inexpensive -- but it doesn't have a strong brand. For instance, a wife will never say "it's from Blue Nile? I love it."

Good luck with this one, though. I will look forward to watching from the sidelines.

One underlying trend that is missing in the analysis is that the first generational of digital natives is only at the very beginning of becoming consumers of these products. The average marriage age in the US is 28 or so. The demographic born from say 1990 onwards has not significantly started buying engagement rings yet.

I would hasten to guess somebody born in the 1990's is going to be far more amenable to buying jewelry on-line. It's just natural to them. Additional this generation is more cost concious and less economically well off than prior generations. Further pressure to stay away from bricks and mortar.

I think this demographic group will become a tail-wind for Blue Nile in a few years.

Part of the reason why bluenile is not growing is because of a superior competitor named jamesallen.com.Jamesallen.com is a privately held company with similar business model to the one of bluenile. I don't know their exact sales figures but based on internet retailer's top 500 publication, they were at ~$80M sales in 2012 and growing fast.Jamesallen.com is different than blunile.com because they show crystal clear 3D images of their diamonds and rings. This makes buying with them a comparable or better experience then walking into a jewelry store and beats any "letters and numbers" (certificate) listed on bluenile. When the Oculus Rift will become available, all you'll need to do is put it on and browse jamesallen.com

I hope you were Dang long DangDang... 32% up post numbers on massive volume. If mkt moves to price to sales to value it will get very interesting. It could have been fun it you could have gotten over the remote thing and that I wasnt techie enough... JM

Engagement rings are just the start, two years ago I bought my wife a set of diamond earrings from Blue Nile (very special occasion). She was very happy. I may be a repeat customer.....in another 23 years, but that's better than just a one off engagement ring.

I commented on this thread 4 years ago that digital natives would be a tailwind for Blue Nile. I didn't even realise how prescient that would turn out to be personally.

Recently, I used BlueNile to buy my partner her Engagement Ring.

After going to the Jewellery District of London (Hatton Gardens), buying online was a far superior process. Here is my rationalisation

* Brand - I'd heard of BlueNile almost 10-15 years ago. None of the stores I went to resonated (Even if it was an old business with storied past, I'd never heard of it). I *trusted* Blue Nile more.* No Haggling - To buy from a physical store requires considerable haggling, a process I don't wish to participate in given my asymmetric knowledge disadvantage vs my counterpart.

What may determine whether BlueNile is successful vs online competitors may be if it has lower customer acquisition costs simply because it has been around for 20 years, selling what is a very "high trust" product.

Engagement Rings are very unusual products, as the purchase is generally a one-off. There isn't much repeat business. I wonder if in these cases, brand premium is worth more as you can't experiment by sending a portion of your business elsewhere. You get one transaction and thus one decision.

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